How to Sell Covered Calls
In a down or flat market, it can be tough to invest or trade. One way to raise cash in a slow market, without selling positions, is to sell covered calls. If you are right about the overall market trend and the trend of your particular stocks, you can generate a modest return while waiting for overall conditions to recover.
Selling Covered Calls in a Slow or Down Market
Selling covered calls is another way to take advantage of a slow or down market.
The tactic is particularly useful when you already have a position in a stock you intend to hold for some time (at least longer than you expect the market downtrend to be). Selling covered calls can take the sting out of the paper losses you must endure while continuing to hold the stock.
The upside of a covered call tactic is immediate cash in your account. The downside is that it ties up your position (until you close the call position) and a possible assignment of your option, which means you must deliver the stock.
However, if you feel that the market is headed down for a while, and you are right, selling covered calls can put cash into your account immediately (subject to clearing) without ever having to deliver the stock to the person who buys the call option.
Meanwhile, you can continue to hold your stock position until the market recovers.
Covered Calls - Definitions
A call is an option that gives the holder the right to buy 100 shares of stock from the selling of the call-option-contract at a specified "strike" price.
The "strike price" is the amount that the holder of a call option will pay if he decides to exercise the option. If the strike price is $50 and the option is exercised, then the holder will pay $5,000 ($50 times 100 shares) to the seller of the option.
The "option price" is the amount that a single option contract costs. Option prices are always quoted in per-share prices, but a single option contract always covers 100 shares. The total cost of purchasing an option is always the "option price" times 100 shares.
An "in-the-money" option is one whose strike price is lower than the currently trading price of the option. The total "option price," however, is usually high enough to prevent the option from being exercised for an immediate profit. When the stock price rises high enough so that the total strike price paid plus the total option price is lower than the total market value of the shares, there is an incentive to exercise the option. Often, option holders will simply sell the option for a profit rather than exercise it. Many times, the purchaser of the option in this case is someone who originally sold the option, with the intent to prevent his actual shares from being called.
A "covered call" is a term describing a call that is sold by a person who already owns enough shares of the stock in question to deliver those shares, if the option is assigned.
"Assigned" means that the person holding a call option makes the decision to exercise it, pay the strike price for the shares and have the stock delivered to him. The "assignment" occurs when the exchange tells the seller that someone has exercised the option and the shares must be delivered. Generally, no action needs to be taken by the option seller; the sales proceeds appear, and the stock is removed from your account.
Please note that you should probably not try this tactic as your first experience with options, however. Start with simply purchasing options. As a purchaser, your potential loss is always limited to the amount you spend for the option itself.
Choices
When you decide to sell a covered call option, there are several choices you need to make:
- Expiration date
- Strike price
- Number of shares
For expiration dates, there are usually several choices of varying length. The longer the expiration date, the higher the premium for the option will be, but the more risk you take that the stock might be called.
There are also usually numerous choices for a strike price. In general, the number of outstanding options at any time is higher for options that are "in-the-money." Choosing an option contract with a higher number of outstanding contracts means greater liquidity. Higher volume can provide better pricing, but also "fresher" bid/ask data (which can sometimes be a problem).
For a "covered call" tactic, the number of contracts you can sell is limited by the total number of shares you already own. You must have at least 100 shares to write a covered call contract. You can sell any number of contracts for which you own 100 shares. For example, if you own 850 shares of a stock, you can sell up to 8 covered call contracts.
After you have made these choices, you are ready to sell the covered call. All you need to know is the ticker symbol for the call option.
Most brokerages provide an "options chain" capability for easy lookup of the ticker symbol. Although there is a standardized convention for option ticker symbols, clicking on the "options chain" link at your online brokerage is a lot easier.
Selling a Covered Call
When you decide to sell a covered call option, you place an order with your broker, just as with any sales order.
The actual steps to place the order vary by brokerage, check with your broker for the exact procedure.
Pricing
As with any sales order, you have the choice of a market or limit order.
Pricing is determined by a bid/ask system, just as with stocks and the same cautions about marker orders exist with options.
The exact price offered for any option is set by the market. The theoretical "correct" pricing involves mathematics that is beyond the scope of this article.
Before placing an order, verify the date of the most recently traded option with the same strike and expiration date. Sometimes, the bid/ask data shown for a particular option can be quite old for a thinly traded contract. If so, do not place a market order to sell the contract.
Receipt of Proceeds
When you sell a covered call, the proceeds from the sale appear in your account as cash. The amount earns interest or offsets your total margin balance, just as a sale or other check deposit would (and unlike short sale proceeds).
However, while the option contract is open, a restriction is placed on your shares. In general, the underlying shares for the stock behind a covered call cannot be sold unless the open call contract is first closed. If the shares were sold prior to the option position being closed, the call would become a "naked" call. Generally, a brokerage firm will not allow an open option contract to convert from covered to naked status while the position is still open.
In addition, the value of the shares behind your open covered call position will not be used to determine your overall margin capability (generally). Selling a covered call lowers your margin capability (in most cases).
The Upside
Selling covered calls provides you with the following benefits in a down market:
- Cash proceeds, which can offset the paper losses during a down market
- The ability to "set your price" for selling the underlying stock
- The holding period for the underlying stock is unaltered by selling the calls. (Important if you are close to the long-term capital gains period)
If all goes well with the "selling covered call" strategy, the option expires without you having to ever do anything. At that point, if you still think the market is headed down, you can sell new covered calls against the very same shares of stock.
The "set your price" concept involves picking a strike price at which you would be happy to sell the stock. For example, if you originally envisioned selling the stock at $50 a share, but the current price is just $42 a share, it may be beneficial to sell a covered call with a strike price of $50. This is what you would have sold for anyway, but by selling the covered call, you increase the total proceeds from your sale.
The Risks
The risks associated with selling covered calls are largely related to the stock price rising unexpectedly and include:
- Having to close your call option position by buying the option at a higher price than you sold it for
- Having to deliver your shares because of the call option being assigned to you
- Limiting your ability to sell the underlying shares while the option is still open
The last risk is probably minimal, as the covered call tactic is primarily designed for situations where you want to continue holding a stock during a down market period.
Before embarking on any covered call sales tactic, you should determine if you would be comfortable selling the stock if the strike price was reached. If not, rethink your approach.
